Ban ‘Pure’ Speculators of Oil Futures – NYTimes.com

The High Cost of Gambling on Oil

By JOSEPH P. KENNEDY II

Published: April 10, 2012

Boston

THE drastic rise in the price of oil and gasoline is in part the result of forces beyond our control: as high-growth countries like China and India increase the demand for petroleum, the price will go up.

But there are factors contributing to the high price of oil that we can do something about. Chief among them is the effect of “pure” speculators — investors who buy and sell oil futures but never take physical possession of actual barrels of oil. These middlemen add little value and lots of cost as they bid up the price of oil in pursuit of financial gain. They should be banned from the world’s commodity exchanges, which could drive down the price of oil by as much as 40 percent and the price of gasoline by as much as $1 a gallon.

Today, speculators dominate the trading of oil futures. According to Congressional testimony by the commodities specialist Michael W. Masters in 2009, the oil futures markets routinely trade more than one billion barrels of oil per day. Given that the entire world produces only around 85 million actual “wet” barrels a day, this means that more than 90 percent of trading involves speculators’ exchanging “paper” barrels with one another.

Because of speculation, today’s oil prices of about $100 a barrel have become disconnected from the costs of extraction, which average $11 a barrel worldwide. Pure speculators account for as much as 40 percent of that high price, according to testimony that Rex Tillerson, the chief executive of ExxonMobil, gave to Congress last year. That estimate is bolstered by a recent report from the Federal Reserve Bank of St. Louis.

Many economists contend that speculation on oil futures is a good thing, because it increases liquidity and better distributes risk, allowing refiners, producers, wholesalers and consumers (like airlines) to “hedge” their positions more efficiently, protecting themselves against unseen future shifts in the price of oil.

But it’s one thing to have a trading system in which oil industry players place strategic bets on where prices will be months into the future; it’s another thing to have a system in which hedge funds and bankers pump billions of purely speculative dollars into commodity exchanges, chasing a limited number of barrels and driving up the price. The same concern explains why the United States government placed limits on pure speculators in grain exchanges after repeated manipulations of crop prices during the Great Depression.

The market for oil futures differs from the markets for other commodities in the sheer size and scope of trading and in the impact it has on a strategically important resource. There is a fundamental difference between oil futures and, say, orange juice futures. If orange juice gets too pricey (perhaps because of a speculative bubble), we can easily switch to apple juice. The same does not hold with oil. Higher oil prices act like a choke-chain on the economy, dragging down profits for ordinary businesses and depressing investment.

When I started buying and selling oil more than 30 years ago for my nonprofit organization, speculation wasn’t a significant aspect of the industry. But in 1991, just a few years after oil futures began trading on the New York Mercantile Exchange, Goldman Sachs made an argument to the Commodity Futures Trading Commission that Wall Street dealers who put down big bets on oil should be considered legitimate hedgers and granted an exemption from regulatory limits on their trades.

The commission granted an exemption that ultimately allowed Goldman Sachs to process billions of dollars in speculative oil trades. Other exemptions followed. By 2008, eight investment banks accounted for 32 percent of the total oil futures market. According to a recent analysis by McClatchy, only about 30 percent of oil futures traders are actual oil industry participants.

Congress was jolted into action when it learned of the full extent of Commodity Futures Trading Commission’s lax oversight. In the wake of the economic crisis, the Dodd-Frank Wall Street reform law required greater trading transparency and limited speculators who lacked a legitimate business-hedging purpose to positions of no greater than 25 percent of the futures market.

This is an important step, but limiting speculators in the oil markets doesn’t go far enough. Even with the restrictions currently in place, those eight investment banks alone can severely inflate the price of oil. Federal legislation should bar pure oil speculators entirely from commodity exchanges in the United States. And the United States should use its clout to get European and Asian markets to follow its lead, chasing oil speculators from the world’s commodity markets.

Eliminating pure speculation on oil futures is a question of fairness. The choice is between a world of hedge-fund traders who make enormous amounts of money at the expense of people who need to drive their cars and heat their homes, and a world where the fundamentals of life — food, housing, health care, education and energy — remain affordable for all.

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